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Strengthening Moats Mean Improving Returns For CRO Investors

The contract research organization industry is shifting away
from contractual trial-by-trial arrangements toward long-term
strategic alliances between the Big Pharma firms and
drug-development service providers. We think this new strategic
partnership model--which is resulting in both increased outsourcing
penetration and market share gains for the industry's leading
players--will fuel strong demand for the top-tier CROs. Strategic
partnerships also increase the stickiness of client relationships,
which we believe creates a positive moat trend for these
narrow-moat firms. Though these secular tailwinds have resulted in
improved earnings and rising valuations for CROs and investors, we
still think some opportunity remains for firms like Icon (
ICLR
) and Charles River Laboratories (
CRL
), which have yet to fully participate in the CRO recovery.

Strong Book/Bill and Double-Digit Backlog Gains Bode Well for
Continued Growth
We think the CRO industry rebound is in full swing, as evidenced by
a resurgence in new business activity and revenue growth during the
past 18 months. Increased outsourcing penetration and market share
gains among the largest CROs are behind these strong new business
wins. After steep declines in 2009, the widespread top-line growth
that began last year has persisted throughout 2012. On average, we
expect the CROs we cover to increase revenue 12% this year.
Encouragingly for future growth, firms continue to turn in
book/bill ratios greater than 1.0, and new strategic alliances have
begun to contribute meaningfully to revenue. The emergence of the
strategic partnership model, which has seen the world's largest
drugmakers pair up with leading CROs as long-term partners in
research and development, has helped fuel this return to growth.
Top-tier CROs, which historically have employed a transactional
model to contract with clients on a trial-by-trial basis, are now
being pursued by Big Pharma firms as strategic partners in drug
development. CROs are being brought to the table earlier in the
clinical trial design process, and trials are increasing in size,
complexity, and global breadth.

Revenue Growth Translates Into Earnings Gains as Resource
Buildups Ebb
Though CROs' top lines began to accelerate in 2011, many firms
experienced a significant lag before revenue gains began to benefit
earnings growth. Resource buildups to support recently signed
partnerships, which require substantial new costs without an
immediate increase in compensating revenue, had weighed most
prominently on earnings for ICON and Parexel (
PRXL
) after being named as the two strategic partners of Pfizer last
May. After going on a hiring spree in order to support the higher
expected future business tied to new large-scale strategic
partnerships, it seems Parexel is finally beginning to reap the
benefits of positive operating leverage as double-digit revenue
gains outpace expense growth. Similarly, ICON is witnessing robust
earnings growth following its third-quarter 2011 low of only $0.02
per share. ICON brought on more than 700 new staff members to build
up its infrastructure in anticipation of new clinical trial work
from Pfizer, and we expect margins to continue improving as
partnership revenue offsets these increased expenses. We expect
2012 results to come in at twice last year's levels, and we think
earnings are set to rise another 50% next year. As a whole, CRO
profitability has improved substantially this year, and we expect
earnings to only accelerate as partnerships mature and productivity
improves further. Furthermore, aggressive cost cuts and share
buybacks during the past few years should also help earnings
outpace revenue growth for the foreseeable future. Conversely,
though we think Chinese CRO WuXi (
WX
) is well positioned to benefit from the dual tailwinds of
increased outsourcing and offshoring of drug-development
activities, revenue gains will continue to outpace earnings growth
amid rising costs in China.

Strategic Partnership Model Strengthens Moats for Late-Stage
CROs
The contract research organization industry appears finally to have
emerged from a prolonged slowdown in drug-development spending.
CROs dramatically cut costs and development time for drugmakers
while also allowing companies to shift to a variable-cost
structure, focus on their core competencies of drug discovery and
marketing, and better adapt to regulatory changes. As cutbacks
continue at major pharmaceutical firms to cope with impending
patent losses, we expect the cost advantages of outsourcing to
persuade Big Pharma firms to hand over an increasing portion of
their drug-development work to CROs. Furthermore, only a few
top-tier contract research providers have the necessary expertise
and infrastructure to conduct large clinical trials around the
world. With drug-development outsourcing rates expected to
increase, we think these firms will continue to gain share at the
expense of smaller competitors. Therefore, even if R&D spending
growth remains flat, we expect increased outsourcing penetration,
market share gains by global CROs, and expansion into emerging and
adjacent markets (such as biosimilars) to drive strong growth for
the sector's major players.

The CRO industry is shifting away from contractual
trial-by-trial arrangements toward long-term strategic alliances
between the Big Pharma firms and drug-development service
providers. We see strategic partnerships as a symbiotic new model.
By winnowing their lists of providers, pharma firms are better
positioned to take advantage of volume rebates based on clinical
trial work. For the CROs, strategic partnerships primarily offer
growth benefits through their potential to increase the market
share of the top providers. Strategic partnerships also increase
the stickiness of client relationships, create more stable cash
flows through long-term contracts, and result in further scale
advantages for top-tier players over their smaller counterparts.
Covance (
CVD
), first and foremost, as well as Parexel and ICON, has been at the
forefront of signing large-scale deals with some of the world's
largest drugmakers, and we believe the new strategic partnership
paradigm is strengthening the competitive advantages of these CROs.
Conversely, though we believe Charles River will continue to
benefit from the secular trend of increased outsourcing, we don't
think it has improved its competitive advantages, based on its
concentration in early-stage development (which is less conducive
to large-scale deals) and history of poor execution.

We Think There Is Still Some Upside Potential for ICON and
Charles River
The CRO recovery has translated into share price gains, and our CRO
coverage universe now trades at less than an 11% discount to our
fair value estimates (versus around 35% at this time last year). We
think rising valuations validate our long-held belief that the
slowdown in drug-development spending was temporary and that the
value proposition offered by these top-tier CROs eventually would
woo a greater share of R&D dollars from drugmakers. Our outlook
for the industry remains bright, and new strategic partnership
announcements could provide additional upside to our fair value
estimates.

Though ICON trades at just a 14% discount to our fair value
estimate, we think there is still some upside potential as earnings
continue to improve going into 2013. The Pfizer partnership is
expected to begin contributing meaningfully to revenue in the
current quarter, and the firm's formerly unprofitable central lab
division is on the mend. We think the firm will return to
double-digit operating margins by the second half of next year as
it leverages its new staff and infrastructure across an expanded
revenue base.

Charles River has yet to come near our fair value estimate of
$50 per share. Though we have concerns regarding the past
capital-allocation issues and the uncertain timing of preclinical
drug-development demand recovery, the firm's valuation remains
compelling. Charles River's operations are divided into two
segments: research models and services, which is a highly
profitable and stable business, and preclinical services, a much
more volatile segment with potential for considerable growth, in
our opinion. Preclinical services have fared poorly in recent years
as clients try to eliminate molecules earlier in the
drug-development cycle and focus R&D spending on late-stage
candidates closer to approval.

Unlike the strong demand witnessed by clinical-stage providers,
early-stage drug demand has yet to recover, and we think Charles
River's preclinical services franchise could provide substantial
upside for investors as demand comes back on line. In the meantime,
the company has been able to lean on its research models and
services business to stabilize earnings and provide a floor for its
depressed valuation.

Given the extremely volatile nature of early-stage demand in
recent years, we are hesitant to call the exact time of the
preclinical rebound. However, a large amount of capacity has not
been removed from the system. We expect conditions to gradually
improve next year and regain full steam in 2014 and beyond because
of the fundamental need to drive new therapies through
development.

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